Inspiration from physics for thinking about economics, finance and social systems

Friday, April 11, 2014

Macroeconomists make a great advance -- or maybe not

By way of Unlearning Economics, who has made the effort of plowing through the details of the paper, read below and see if you've ever had a similar experience while reading some new and allegedly exciting "advance" in macroeconomic theory:

How Not to Do Macroeconomics

A frustrating recurrence for critics of ‘mainstream’ economics
is the assertion that they are criticising the economics of bygone days:
that those phenomena which they assert economists do not consider are,
in fact, at the forefront of economics research, and that the critics’
ignorance demonstrates that they are out of touch with modern economics –
and therefore not fit to criticise it at all.

Nowhere is this more apparent than with macroeconomics.
Macroeconomists are commonly accused of failing to incorporate dynamics
in the financial sector such as debt, bubbles and even banks themselves,
but while this was true pre-crisis, many contemporary macroeconomic
models do attempt to include such things. Indeed, reputed economist Thomas Sargent
charged that such criticisms “reflect either woeful ignorance or
intentional disregard for what much of modern macroeconomics is about
and what it has accomplished.” So what has it accomplished? One attempt
to model the ongoing crisis using modern macro is this recent paper
by Gauti Eggertsson & Neil Mehrotra, which tries
to understand secular stagnation within a typical ‘overlapping
generations’ framework. It’s quite a simple model, deliberately so, but
it helps to illustrate the troubles faced by
contemporary macroeconomics.

The model

The model has only 3 types of agents: young, middle-aged and old. The
young borrow from the middle, who receive an income, some of which they
save for old age. Predictably, the model employs all the standard
techniques that heterodox economists love to hate, such as utility
maximisation and perfect foresight. However, the interesting mechanics
here are not in these; instead, what concerns me is the way ‘secular
stagnation’ itself is introduced. In the model, the limit to how much
young agents are allowed to borrow is exogenously imposed, and
deleveraging/a financial crisis begins when this amount falls for
unspecified reasons. In other words, in order to analyse deleveraging,
Eggertson & Mehrotra simply assume that it happens, without asking
why. As David Beckworth noted on twitter,
this is simply assuming what you want to prove. (They go on to show
similar effects can occur due to a fall in population growth or an
increase in inequality, but again, these changes are modelled as
exogenous).

It gets worse. Recall that the idea of secular stagnation is, at
heart, a story about how over the last few decades we have not been able
to create enough demand with ‘real’ investment, and have
subsequently relied on speculative bubbles to push demand to an
acceptable level. This was certainly the angle from which Larry Summers and subsequent commentators approached the issue. It’s therefore surprising – ridiculous, in fact – that this model of secular stagnation doesn’t include banks, and has only one
financial instrument: a risk-less bond that agents use to transfer
wealth between generations. What’s more, as the authors state, “no
aggregate savings is possible (i.e. there is no capital)”.Yes, you read that right. How on earth
can our model understand why there is not enough ‘traditional’
investment (i.e. capital formation), and why we need bubbles to fill
that gap, if we can have neither investment nor bubbles?

Naturally, none of these shortcomings stop Eggertson & Mehrotra
from proceeding, and ending the paper in economists’ favourite
way…policy prescriptions! Yes, despite the fact that this model is not
only unrealistic but quite clearly unfit for purpose on its own terms,
and despite the fact that it has yielded no falsifiable predictions (?),
the authors go on give policy advice about redistribution, monetary and
fiscal policy. Considering this paper is incomprehensible to most of
the public, one is forced to wonder to whom this policy advice is
accountable. Note that I am not implying policymakers are puppets on the
strings of macroeconomists, but things like this definitely contribute
to debate – after all, secular stagnation was referenced by the Chancellor in UK parliament (though admittedly he did reject it). Furthermore, when you have economists with a platform like Paul Krugman endorsing the model, it’s hard to argue that it couldn’t have at least some degree of influence on policy-makers.

11 comments:

Any rates increase should be determined by social level rise. And it doesn’t matter if it would be average prices, loans for emergency costs, or stock quotes. Society’s wealth is the main reason of economic and political functioning.

Fine piece of writing. This quote is one I need to take with me, something to recite to others over and over again:

"What’s important is how money and resources move around: where they come from, and how they are split – on aggregate – between investment, consumption, financial speculation and so forth. This type of methodology can help understand how the financial sector might create bubbles; or why deficits grow and shrink; or how government expenditure impacts investment."

The most resilient things we build as humans are not our physical structures, but our social structures. Those structures start as habit, they become ritual and, oh so gradually that it rarely touches on human perception, they take on the trappings of full blown religious dogma complete with a rich set of rituals.

Macroeconomic theory is just such a social structure. It long ago attained religious status. It comes complete with an academic priesthood and, as detailed in the article's critique of the tautological assumptions that find their way into so much of that priesthood's arguments, a rich set of ritualistic incantations.

Digital technology and the sort of agent modelling it allows will, of course, sweep much of this away. Resistance will be futile. It will be good fun, however, watching those who've tried to ignore that incoming wave try to ride it as it blows past them.

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This blogexplores the potential for the transformation of economics and finance through the inspiration of physics and the other natural sciences. If traditional economics has emphasized self-regulation and market equilibrium, the new perspective emphasizes the myriad positive feed backs that often drive markets away from equilibrium and cause tumultuous crashes and other crises. Read more about the idea.

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Physicist and science writer. I was formerly an editor with the international science journal Nature and also the magazine New Scientist. I am the author of three earlier books, and have written extensively for publications including Nature, Science, the New York Times, Wired and the Harvard Business Review. I currently write monthly columns for Nature Physics and for Bloomberg Views.